High tax rates have led to shadow economy worth over £150 billion, new research shows

New research published today by the Institute of Economic Affairs reveals that high tax rates have resulted in a shadow economy equivalent to a staggering 10% of GDP, worth in excess of £150 billion.

High levels of government spending and front-loaded tax rises have pushed both individuals and businesses into illicit employment. This is a dangerous cycle. As more people have been forced into the shadow economy, HMRC has lost tax revenue. This in turn has pushed up tax rates, stimulating black market employment even more.

The report, The Shadow Economy, finds overwhelming evidence that punitive tax regimes have led to the shadow economy employing 30 million people across the European Union. In Italy, Greece and Spain, illicit activity makes up around 20% of national income.

Causes:

Tax and welfare burdens. Employment costs in the official economy have risen as after-tax earnings from work have declined. This has encouraged both workers and businesses to reduce their tax liabilities by abandoning formal employment.

Regulation. Ever-increasing levels of regulation have dramatically pushed up labour costs. These costs have been pushed on to employees through lower wages, pushing workers into the shadow economy where they can be avoided.

Recession. The financial crash and subsequent recession saw unemployment rise, reducing jobs in the mainstream economy. Ballooning tax rates exacerbated this as the government attempted to reduce the budget deficit.

Lack of trust in the government. With higher tax rates encouraging more people out of formal work, people increasingly perceive the tax system as unfair, increasing the likelihood of them also looking for illicit employment.

To reduce shadow economic activity, the research recommends:

Simplifying regulatory compliance. Lowering the costs and complexity of regulation would increase tax compliance. This would be a significant boost to small companies, where compliance costs per worker are often much higher.

Allowing the self-employed and small businesses to formalise their working arrangements. Some 55% of all shadow economy work consists of small-scale intermittent work done by family, friends and neighbours. Much of this could be legitimised overnight if the government allowed people to earn up to a certain amount tax-free and without declaration.

Tax amnesties. These would allow undeclared activities to gradually move towards the official economy over a period of two years with no sanctions. At the end of the period stronger sanctions would be imposed on those continuing to work in the shadow economy. There is a strong economic case for amnesties due to the incentives they create. There may be individuals wanting to regularise their business activities, but who will not through fear of harsh and unpredictable penalties.

Social security burdens. In western Europe, shadow work is not only prevalent among the formally employed. Policies should also focus on the welfare system. Welfare-to-work schemes could help reduce the incentive to undertake shadow work while receiving benefits.

Commitment measures to encourage tax morality. Low tax morality leads to larger shadow economies, and more lost revenue for HMRC. Awareness and information campaigns should focus upon the benefits of formal work, not the risks and costs of the shadow economy.

Commenting on the research, Professor Philip Booth, Editorial Director at the Institute of Economic Affairs, said:

“Funding excessive spending with high levels of tax has been a boon for the black market. With the shadow economy now worth over £150 billion in the UK, it’s time for urgent action. The government must make legal work easier and more beneficial by providing incentives for those working in the shadow economy to move to the formal sector. At the same time radical action is needed to reduce the burdens of taxation and red tape which led so many into the black market in the first place.”

The full report, The Shadow Economy, can be downloaded from www.iea.org.uk[4].

Friedrich Schneider has been Professor of Economics at the Johannes Kepler University of Linz, Austria since 1986. He obtained his PhD in Economics from the University of Konstanz in 1976 and has held numerous visiting and honorary positions at a number of universities. He was the European editor of Public Choice from 1991 to 2004 and he has published extensively in leading economics journals, including the Quarterly Journal of Economics, the American Economic Review, the Economic Journal and Kyklos. He has published 67 books, 196 articles in scientific journals and 171 articles in edited volumes.

Colin C. Williams is Professor of Public Policy and Director of the Inter-disciplinary Centre of the Social Sciences (ICOSS) at the University of Sheffield. His recent books include The Role of the Informal Sector in Post-Soviet Economies (Routledge, 2013), Informal Work in Developed Nations (Routledge, 2010), Rethinking the Future of Work: Directions and Visions (Palgrave Macmillan, 2007), The Hidden Enterprise Culture (Edward Elgar, 2006) and Cash-in-Hand Work (Palgrave Macmillan, 2004).

The mission of the Institute of Economic Affairs is to improve understanding of the fundamental institutions of a free society by analysing and expounding the role of markets in solving economic and social problems.

The IEA is a registered educational charity and independent of all political parties.